Market Insights

Decentralized Exchanges: Further Disruption Ahead?

Today’s digital currency exchanges are centralized, meaning that intermediaries (e.g., Coinbase, GDAX, Kraken, Gemini) operate as escrows, and sometimes central counterparties, for their users. They keep a centralized “off-chain” balance sheet that records the balances and trades of their users. Customer transactions generally are not recorded on blockchain associated. This centralized approach to digital currency today has drawbacks. There have been breaches of security and concerns about storage of information, funds, and private keys (see also, Blockchain Graveyard). Further, centralized exchanges have proven vulnerable to hacks, and may react poorly to unusual blockchain events like hard forks.

Decentralized exchanges (“DEXs”) aim to tackle these problems by building peer-to-peermarketplaces directly into the blockchain . At their core, DEXs allow buyers and sellers to (1) retain custody of their own assets, (2) view the entire order book, and (3) execute trades anonymously (or at least, pseudonymously) in a direct peer-to-peer manner – without the involvement of a central intermediary. Admittedly, a “true” DEX remains today something of a utopia because many of today’s DEXs use servers that host order books but importantly, they do not hold private keys.

While DEX developers and their investors see this technology as an opportunity to lessen the risk involved in exchange activity from a user perspective, decentralization raises interesting and nuanced questions in light of a financial system premised on regulating intermediaries.

The Current State of the Market

There are two types of decentralized exchanges: (1) exchanges for cryptoasset-to-cryptoasset trading (“crypto-to-crypto DEXs”) and (2) exchanges for fiat-to-cryptoasset trading (“fiat-to-crypto DEXs”). While both of these types of exchanges are in their early stages of development, crypto-to-crypto DEXs seem to be further along in terms of development and user adoption.

For example. The crypto-to-crypto exchange Radar Relay is a non-custodial, peer-to-peer software that displays and manages orders but does not itself hold assets or execute trades. Users on the Radar Relay platform can find and complete orders, which are settled on the Ethereum blockchain through smart contracts built on a protocol called 0x (pronounced “zero-ex”), which is a protocol specifically designed to facilitate the peer-to-peer exchange of ERC20, or “Ethereum-based,” tokens. For now, crypto-to-crypto DEXs such as Radar Relay do not require users to submit personal information. Users can create an account and begin trading without much beyond watching a step-by-step tutorial on how to use the platform.

An example of a fiat-to-crypto DEX is Bisq, an open-source desktop application that allows users to buy and sell cryptoassets such as bitcoin in exchange for fiat currencies or other cryptoassets. It operates as a peer-to-peer network over Tor, an anonymous communication routing network commonly referred to as the “deep web” or the “dark web.” This means that there are no servers hosting the service. Similar to Radar Relay, Bisq does not hold any user funds and does not require registration. For U.S. users, bank transfers seem to be currently disabled. However, PayPal and Chase QuickPay are as of this writing still active.

DEXs are in the early stages of user adoption, so these markets lack liquidity compared to the more popular centralized exchanges (e.g., Coinbase, GDAX, Kraken, Gemini). Further, they require users to manage the security of their own funds, and tools for that (e.g., hardware wallets such as Trezor and Ledger) are still immature.

However, given concerns about centralized exchanges continue users may continue to seek out alternatives. Further, decentralized exchange protocols such as 0x hold promise for further innovation because such protocols create open standards that are easy for other developers to customize. For example, dYdX, a venture-backed protocol for financial derivatives trading, is being built on 0x.

Regulation of DEXs as Money Service Businesses

The Bank Secrecy Act and the regulations enacted thereunder (the “BSA”) establish extensive requirements for certain financial institutions, including with respect to record-keeping and proactive reporting of suspected money laundering. Under the BSA, “financial institution” is defined broadly and includes money services businesses (“MSBs”) such as “money transmitters.” A “money transmitter” is a person or entity that provides “money transmission services” or any other person engaged in the transfer of funds, subject to certain exceptions.

In March 2013, FinCEN, the federal regulatory agency responsible for enforcing compliance with the BSA, issued interpretive guidance(the “Guidance”) to clarify how the BSA—particularly, the definition of MSBs—applied to persons creating, obtaining, distributing, exchanging, accepting, or transmitting virtual currencies. Such persons are classified into “users,” “administrators,” or “exchangers.”

Under the Guidance:

A “user” is a person that obtains convertible virtual currency to purchase goods or services on their own behalf. Users are expressly carved out of the MSB definition.

An “administrator” is a person engaged as a business in issuing (putting into circulation) a convertible virtual currency, who also has the authority to redeem (to withdraw from circulation) said convertible virtual currency.

An “exchanger” is a person engaged as a business in the exchange of convertible virtual currency for real currency, funds, or other convertible virtual currency. This may present issues for DEX developers or operators, as discussed below.

A “convertible virtual currency” is defined as virtual currency that either has an equivalent value in real currency or acts as a substitute for real currency.

Under the Guidance, the key question is whether DEX developers and operators are operating “as a business.” Whether a person operates “as a business” is a matter of facts and circumstances. One fact that would certainly be relevant to the “as a business” analysis is whether the developers or maintainers of the DEX in question are organized as a for-profit business, or instead, whether they are a loosely affiliated group of individual developers gratuitously contributing to the technology on an open-source basis without any one developer or coordinating group operating the DEX as a business.

It is possible, for example, that Radar Relay is operating “as a business.” First, as discussed above, it currently maintains the order book, meaning that there is arguably some degree of centralization, despite the fact that Radar Relay is non-custodial. Its FAQ page indicates that, while its beta version has no fees, it intends to address fee structure at some point “after the beta concludes.” The fact that Radar Relay discusses a fee may not be dispositive in determining whether they are transmitting virtual currency “as a business” but it likely would be an important factor in the assessment.

Bisq is less centralized still and therefore more arguable. Bisq is open-source software that has been expressly placed in the public domain. Bisq does not maintain a centralized server for any reason—for example, to host an order book. No central company, organization or administrator has retained any rights to Bisq or has stated an intention to profit from Bisq. Interestingly, even if a determination were made that Bisq is acting “as a business,” it is unclear who Bisq actually is. Would it be the eleven “team members” listed on Bisq’s GitHub.

DEXs are a fascinating market concept that presents interesting and nuanced questions in light of a financial system premised on regulating intermediaries.

Key Takeaways:

Decentralized exchanges are exchange markets where buyers and sellers custody their own assets and execute anonymously (or at least, pseudonymously), in a peer-to-peer manner, directly on the relevant blockchains. This all occurs without either party ever needing to trust or transact through a centralized intermediary.

While DEXs may offer benefits to users cryptoasset ecosystem.

The U.S. financial regulatory framework is premised on the regulation of intermediaries and gateways to the financial system. Accordingly, decentralized exchanges present novelregulatory questions.

One example in how these DEXs would be treated under FinCEN are regulation MSBs, which are premised on a person operating an organized business.

Regulatory Updates

New York Attorney General Launches Inquiry Into Crypto Exchanges

On April 17, 2018, the then-New York Attorney General (“NYAG”) launched the Virtual Currency Markets Integrity Initiative and sent a questionnaire to 13 prominent cryptocurrency exchanges. Among other topics, the questionnaire covers ownership and control, basic operation and fees, trading policies and procedures, internal controls, privacy and money laundering, and protection against risks to customer funds. In his letter to these exchanges, the Attorney General framed the questionnaire as relating to consumer protection:

As with other emerging sectors, the challenge with virtual currency is to prevent fraud and other abuses, safeguard market integrity, and protect individual investors—without stifling legitimate market activity or innovation. [The Attorney General’s] Virtual Markets Integrity Initiative seeks to advance these objectives by promoting meaningful transparency, accountability, and the opportunity for government agencies, consumer advocates, and investors to compare the policies, procedures, and protections of virtual currency platforms.

Of the 13 exchanges to which the questionnaire was sent, several are regulated by the New York Department of Financial Services (the “DFS”) under the BitLicense regime or otherwise have authority to engage in virtual currency business activity. Coinbase, Circle, and bitFlyer USA hold BitLicenses (the fourth BitLicensed firm, Ripple, does not operate a cryptocurrency exchange and was not sent a questionnaire by the NYAG). Gemini and itBit hold New York limited purpose trust company charters with authority to engage in virtual currency business activity. Tyler Winklevoss, the CEO of Gemini, said that his firm “applauds the Attorney General’s focus on this industry and the Virtual Markets Initiative,” and noted that “we look forward to cooperating with and submitting our responses to the questionnaire that has been circulated.”

Two exchanges that received questionnaires from the NYAG, however, had previously discontinued servicing New York customers because they did not want to become subject to the BitLicense regime. The CEO of one of these exchanges, Kraken, posted a rebuttalon the company’s blog challenging the jurisdiction of the NYAG to require Kraken to respond and refusing to comply with the questionnaire.

The Virtual Currency Markets Integrity initiative represents the latest effort by state regulators to exercise oversight of cryptocurrency firms. State securities regulators in Massachusetts and Texas, along with other states, have brought actions against on Initial Coin Offerings that they allege to be in violation of state securities laws. At the federal level, too, Congress has recently held hearings with Securities and Exchange Commission Chairman Clayton and Commodity Futures Trading Commission Chairman Giancarlo to explore gaps in regulatory oversight of cryptocurrency, particularly with regard to spot virtual currency platforms that are often licensed by states as money transmitters but not regulated at the federal level.

As the regulatory framework around cryptocurrencies continues to evolve, this initiative shows that New York intends to continue playing an active role.

Key Takeaways:

With the stated goal of preventing fraud and other abuses, the New York Attorney General launched the Virtual Currency Markets Integrity Initiative and sent a questionnaireto 13 prominent cryptocurrency exchanges.

Many of these exchanges intend to respond to the questionnaire—but at least one exchange, which left New York to avoid the BitLicense regulation, has stated that it will not.

The Virtual Currency Markets Integrity initiative represents the latest effort by state regulators to exercise oversight of cryptocurrency firms and shows that New York will continue to play an active role in that effort.

European Blockchain Partnership Declaration officially signed!

On April 10, 2018, more than three quarters of European countries signed a declaration relating to the establishment of a European Blockchain Partnership, intended to act as a vehicle to foster cooperation among Member States in the exchange of technical and regulatory expertise. This declaration, and the partnership that it creates, follows the launch in February 2018 of the EU Blockchain Observatory and Forum, designed to help cultivate new blockchain opportunities in Europe. The stated goal of the partnership is to ensure that Europe continues to play a leading role in the development and roll-out of blockchain technologies.

The Blockchain Observatory and Forum.

In Europe, innovators and entrepreneurs are already offering blockchain-based solutions, and major participants from traditional financial sectors, such as banks and insurance companies, are engaged in blockchain technology pilot projects. To encourage these initiatives, the European Commission has been funding blockchain projects since 2014 through the EU’s research program “Horizon 2020.” This program aims at investing in a wide range of innovation companies, including blockchain-related startups, with nearly € 80 billion of funding available over 7 years (from 2014 to 2020). The funding for projects supporting the use of blockchain has already reached € 80 million, and € 300 million should follow by 2020.

In this context, the EU Blockchain Observatory and Forum was launched in February 2018 as a European Parliament pilot project, intended to support the Commission’s work on FinTech and to play an active role in helping European companies to build expertise in the field. It is gathering information, analyzing trends, enabling cross-border cooperation on practical cases, and bringing Europe’s top experts together to promote an open forum for blockchain technologists, innovators, citizens, industry stakeholders, public authorities, regulators and supervisors, to discuss and develop new ideas.

The European Blockchain Partnership.

In October 2017, the European Council asked the European Commission to present a European approach to blockchain, and invited the Commission to put forward initiatives for strengthening the framework conditions that enable the EU to explore new markets and to reaffirm the leading role of its industry.

Following the launch of the EU Blockchain Observatory and Forum, 22 European countries (Austria, Belgium, Bulgaria, Czech Republic, Estonia, Finland, France, Germany, Ireland, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Norway, Poland, Portugal, Slovakia, Slovenia, Spain, Sweden and the UK) signed the Declaration on the establishment of the European Blockchain Partnership, to which all members of the EU, the European Free Trade Association, and the European Economic Area have been invited to join.

The signatories of this declaration recognize the potential of distributed ledger technology to transform digital services in Europe and agree to establish this partnership in order to harness the many opportunities of this technology and avoid a fragmented approach, with a view toward developing a blockchain infrastructure across borders within the Digital Single Market and through tailored EU laws and clear governance models.

Going forward, the signatories will each designate a representative to work with the European Commission in order to complete the following actions: (i) by September 2018, identifying an initial set of existing cross-border digital public sector services that would gain added value from the support of a blockchain services infrastructure, and (ii) by the end of 2018, assisting the Commission in preparing the technical specifications of this initiative, defining the appropriate governance model and identifying other framework conditions which are essential to its success (including compliance with regulatory requirements).

Key Takeaways:

Following the launch of the EU Blockchain Observatory and Forum, designed to help Europe to show leadership in the field of blockchain, 22 European countries signed a Declaration, on April 10, 2018, relating to the establishment of a European Blockchain Partnership.

The signatories of this Declaration, which is part of a broader EU-wide policy to create a Digital Single Market across the EU, will work together towards realizing the potential of blockchain-based services by fostering cooperation among Member States.

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